This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 by Leonard W. Wang. All rights reserved.

Monday, September 15, 2008

The Wall Street Bubble Bursts: Unraveling a Bet on Government Policy

Today, September 15, 2008, the Dow Jones Industrial Average dropped 504 points. The proximate cause of this downturn was the bankruptcy filing of Lehman Brothers and highly publicized problems at other financial services firms, such as Merrill Lynch, American International Group, and Washington Mutual. Even well-regarded firms such as Goldman Sachs and J.P. Morgan Chase are experiencing downdrafts in their stock prices. The Wall Street bubble is bursting.

There are different ways to explain the bubble and its demise. Wall Street took on too much risk, based on a belief that it could be spread around with increasingly complex derivatives contracts. The big banks relied too much on historical data showing that real estate prices had never dropped on an aggregate national level since World War II. They borrowed extraordinary amounts, becoming more leveraged than many hedge funds. They believed themselves too big to be allowed by the government to fail, and acted like teenagers in the driver's seat who believe they won't make a mistake. Perhaps less well understood, though, is that Wall Street made a bet on government policy, a bet that started off well but ended badly.

Since the inauguration of Franklin Roosevelt in 1933, the federal government has taken a greatly increased role in the nation's economy. It insures bank deposits, regulates stock markets on a national scale, uses fiscal, monetary, tax and other policies to promote economic stability and growth, and buffers citizens from the colder, harsher winds in the capitalist world with unemployment insurance, Social Security, Medicare and Medicaid. Americans became accustomed to federal assistance whenever times got tough.

The government's policies did more than just soften the edges for individual citizens. They also took risk out of the markets, especially the real estate and financial markets. Federal agencies created to promote financing for home purchases, such as Fannie Mae, Ginnie Mae, the FHA and Freddie Mac, did much to support and perhaps increase real estate prices. Federal bank regulation, especially the central bank administered by the Federal Reserve and federal deposit insurance, buffered bankers from real world risks of poor operational performance and ensuing deposit flight. It became easy for financiers to become complacent, and they did what came easily. If you don't have to face the downsides of risk, it makes sense to take on more risk and increase your potential for profits. To make things even more copacetic, the Federal Reserve maintained an easy money policy starting in the mid-1990s, lowering everybody's cost of doing everything and making risk seem attractive rather than dangerous.

However, a copperhead remains a copperhead even if you put lipstick on it. And, contrary to the conventional wisdom of the Fed fast money days, chickens retain the habit of coming home to roost.

When the mortgage crisis and credit crunch broke in the summer of 2007, the federal government rode to the rescue, as had come to be expected. Casting aside considerations of moral hazard and burdens on taxpayers, the Fed became a lender, sometimes of first resort, for a variety of financial institutions (and not just commercial banks), accepting both good and potentially murky assets as collateral. Then, when Bear Stearns nosedived in March 2008, the Fed issued a $29 billion check to J.P. Morgan to induce it to buy Bear Stearns. Just last week, the Treasury Department nationalized Fannie Mae and Freddie Mac, in order to prevent worldwide financial distress.

But bailouts cost money, and no government has unlimited resources. The U.S. government was relying on its borrowing power to finance these bailouts. But its deficits are humongous, and growing rapidly. America's overseas creditors have lately been frowning at the dollar, and quietly shifting wealth into other currencies. Smelly things were getting close to the fan. The Treasury Department apparently realized that it couldn't keep signing chits for Wall Street bailouts, not when firms the size of Lehman, Merrill, AIG and Washington Mutual belly up to the bar for their drinks on the house. So Lehman wound up in bankruptcy, Merrill was bought by Bank of America, and AIG and Washington Mutual are selling whatever apples they can on the sidewalk.

Much of Wall Street bet that the government would continue its policies of subsidizing real estate and protecting the largest financial institutions. The government's early response to the financial crisis only fueled these beliefs. But too many banks made too many bad mortgage loans for the government to absorb. Government policy can't be implemented beyond the government's resources. Wall Street's bet on government policy turned out to be a bad bet.

The largest financial institutions now realize that, for the first time in decades, they are exposed to market risk. Indeed, the government's new policy is to expose them to market risk. This likely means more losses, writeoffs, acquisitions and perhaps bankruptcies. The stock market is more likely to fall than rise in the near term. Main Street will lose much of its credit as banks' capital levels shrink, diminishing their ability to lend. Economic activity will probably slow and a recession would hardly be surprising.

Not that all is bad. Requiring Wall Street to reckon with market forces, unsoftened by government largess, will strengthen the financial services industry. The strength of any industry ultimately rests not in the quantity of its capital but the perspicacity and wisdom of its leaders. Few of Wall Street's current or recent leaders have proven to be strong. A good thrashing by market forces will change the picture. It remains to be seen whether the government will yet feel compelled to step in and once again administer financial methadone. But sparing the rod has only spoiled the executive suite. And a lot of Wall Street executives have spoiled a lot of things for a lot of other people. It's time for change.

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